Value Based Pricing Saves the Day!
by George E. Cressman, Jr.

Hammered by competitive thrusts and pressured by customer demands for lower prices, companies are increasingly finding prices in a downward spiral. Today many firms face slowing sales and growth. With many industries struggling with overcapacity, price wars are likely to both continue and intensify. Marginal competitors will use price to avoid failure, while better managed competitors will use price in an attempt to hold position. And, making it even worse, customers have become emboldened - they actively seek price competition among their suppliers.

When competitors are aggressively moving price down and customers demand lower prices, refusing to respond means volume loss. In the short term, lower volume is often seen as an evil worse than lower price - for firms with larger levels of fixed cost, lower volume means higher unit cost. And the impact on profitability is readily apparent. Senior executives typically insist this problem be addressed through price moves, and in the short term, sales may be saved.

However, a longer term problem emerges. When price is cut to close sales, often competitive price wars follow. Further, customers learn that demands for lower prices are rewarded - they get lower prices. So they are trained to increase demands for lower - they get what they ask for.

Are customer demands for lower price a pricing problem? Often the answer is no! Customer demands for lower price may be caused by:

  • Targeting the wrong customers - Your offering may be poorly designed for the customers you are pursuing, resulting in their ignoring the value of your offering.
  • Inadequate differentiation - You may not have enough differentiation in your offering and customers may see your offering more as a commodity.
  • Too much offering - You may be delivering much more than customers need, and customers are unwilling to pay for benefits they cannot realize.
  • Failure to communicate - You may not be communicating (in advertising and selling scripts) the benefits and value customers receive using your offerings. And, you may not be asking customers to pay for these benefits and value.
  • Negotiating success - In the past customers may have negotiated lower price with little or no penalty - and so they learn to aggressively demand lower prices.
  • Competitive offering - Customers may have access to a competitive offering delivering equivalent benefit and value but at a lower price.

Price cuts should only be considered when customers really do have a competing offering delivering equivalent value at lower price. In all other cases, price cuts may win the order in the short run, but the deeper problem remains unsolved. When customers are asking for price cuts, management's reaction should never be to consider how deep the price cut should be. Instead, the most important priority for management should be to determine what the real problem is.

Our experience indicates companies consistently set themselves up for customer price aggression. Here's what we often find:

  • Poor customer targeting - Many companies see every customer as a potential customer. Companies who successfully target look for customer segments where they can deliver unique value at competitive advantage.
  • Product focus - Rather than making it clear how customers will benefit and receive value using a supplier's offerings, many companies focus on their products and services - assuming customers will understand and acknowledge the benefit and value inherent in using the offerings.
  • Inadequate understanding of the value of services - Many product suppliers add services to their offerings, hoping these services will be an incentive for customers to buy. These services don't always create value, and even when they do, many managers are unaware of the delivered value.
  • Inadequate offering variety - Many suppliers try to stretch a limited number of offerings across the entire market. This approach does not account for differences in value delivery across customer segments. Some customers receive little value and demand other prices. These lower prices spread across the market, and customers who receive higher value - and would pay for it - are not asked to pay for it.
  • Poor competitive management - Rather than focus on creating unique value for target segments and building competitive advantage, managers sometimes pursue market share using price as a competitive weapon. This trains customers the only variable that matters is lower price, and drives competitive price wars.
  • Poor selling tactics - Sales forces are not given the tools to negotiate value delivery - leaving price as the only negotiating lever. In many cases sales people are even incented to deliver large volume - but not necessarily profitable - sales.

All of these practices drive an increasing focus on price among customers, the sales force and competitors, driving lower profitability.

What a dismal picture. What can managers do? Fortunately there are some tested and proven tools for dealing with these problems. Successful management of these problems involves:

  1. Clearly targeting customer segments where unique value can be delivered at competitive advantage.
  2. Focusing the entire organization and all of its activities on value creation and delivery for target customer segments.
  3. Reducing and eliminating the damage of price negotiations.

We'll look at each of these elements and provide some insights into how successful companies are managing their challenging markets.

Customer Targeting

Segmentation is the holy grail of marketing. Managers are urged to segment markets, defining differences between customer groups. Unfortunately segmentation seems to have acquired an almost mystical aura, and is frequently seen as the objective of marketing activity. Equally unfortunate is that segmentation does not always produce desired results: differences between customer groups may become obvious, but it is not at all obvious how these differences can be exploited in the market.

The real reason for segmentation is not to define differences between customers. Instead, the purpose of segmentation is to identify which specific customer groups should be targeted through the firm's marketing, operational, and sales activities. Of course understanding differences between customer segments is a pre-cursor to selecting targets. But when managers see segmentation as the tool to focus marketing, operational, and sales activities, what must be known about differences between segments becomes key.

Traditionally, segmentation has relied heavily on demographic or application descriptors; variables like location, size, or industry classifications. While such variables do indeed identify different segments, they often do not provide insights into which segments to target and how to capture position in these segments.

To create a value based marketing process - one that results in pricing for value created - managers need to know more about their customers. The first thing managers need to understand is their customers' business models - what drives success in the customer's business and how the customer makes money. Demographic and application segmentation doesn't produce that kind of information; managers must dig deeper, learning the customer's operations and marketing strategies and activities.

But management must know even more. In order to chose segments the firm can profitably target, managers must understand how they can impact the customer's business model. The goal is to define unique offerings that are:

  • Positioned for differential value delivery: The objective is to provide both what contributes to customers' ability to make money and what competition cannot provide.
  • Delivered through competitive advantage: The objective is to deliver value in a way that allows the firm to drive its own profitability.

The problem for most companies is that managers think in terms of what they sell, not what customers buy. Suppliers sell the features of their products and services. But customers buy something different; customers buy what happens when they use the supplier's product. For example, a chemical manufacturer does not buy pumps; while they physically pay for the pump, they really want the pump to transport liquids from one place to another. The chemical firm is using the pump to get liquids from where they are to where they need to be; if there was some other way to move the liquid, the chemical firm might not use pumps at all.

Customers buy outcomes - what happens when they use a supplier's product or service. This outcome - the interaction of the customer with the product/service - is called a benefit. If managers are to get paid for what they supply to customers, the first step is understanding what benefits customers are seeking. An effective segmentation scheme - one that facilitates tailoring of offerings for profitable pricing - is based on understanding the different benefits customer segments seek.

The next step in value based marketing is understanding what economic consequences these different benefits create for the customer. For example, if our chemical firm buys a pump that is more reliable then there are economic consequences arising from that purchase. First, greater reliability means less maintenance work; increased reliability leads to lower costs. Second, greater reliability means the chemical firm can produce more product (there are fewer plant outages from broken pumps); increased reliability also means higher revenue.

These economic consequences are called value - the monetary worth of cost reductions and/or revenue increases the customer experiences using a supplier's products and services. In order to be paid fairly for the benefits a supplier's product/service creates for the customer the supplier must know what these economic consequences - the value, or monetary worth - is.

Three points are important:

  • Value is relative. Look at the language used to describe the pump manufacturer's offering: it is more reliable. All benefit is relative; relative to the next best competitive offering. If a supplier is going to get paid for value delivery, then customers must get more benefit than they can get from a competing alternative. Management must understand what the competition is and how customers differentially benefit using their offering. You won't get paid a price premium doing just what the competitor does; you must deliver benefit (and its associated value) that customers can't get elsewhere.
  • You must understand value. It is important to understand benefits customers receive using your offering. However, if you don't understand the monetary value - the economic consequences - you won't know what you're worth. So, you must quantify the impact of your offering as it lowers the customer's costs and/or increases the customer's revenue.
  • You must communicate value. It must become obvious to customers that you know as well as they do what you are worth. In fact, our experience suggest customers often don't know the value of their suppliers' offerings, and must be regularly reminded.

So in order to implement value based marketing - the route to getting paid for value delivery - you must understand your value delivery to different customer segments. Choosing target segments should be driven by defining those segments where high levels of unique - differentiated - value can be delivered. This means you understand their businesses and you tailor your offerings to create benefits customers in your target segments can't get from competitors.

Most firms will find it difficult to serve the entire market by tailoring offerings that create unique benefits for every segment. The reason is competition can serve some segments better. So what management must determine is which segments can be served through delivery of unique benefits at competitive advantage. What is competitive advantage? Competitive advantage is the ability to serve a segment more efficiently than competitors. There are many sources of competitive advantage; exploring these sources of competitive advantage is beyond the scope of this paper. In order to continue to create unique benefits for the targeted customer segments, managers must invest in and continue to develop the means to efficiently deliver the unique benefits. When competitors can deliver the same level of benefit, the offering becomes a commodity (no matter how much value customers receive), and the lowest cost supplier wins the competitive battle.

Focusing the Organization

Many companies employ functional organizations, typically with operations, marketing and sales, finance and accounting, and technical departments. This is a time tested organizational form, and often helps achieve functional excellence and productivity. But there is a problem with functional organizations: they often create functional excellence at the expense of value delivery to customers, and sometimes at the expense of profitability. What seems to happen with many functional organizations is that they strive to increase efficiency but not necessarily effectiveness. That is, functional organizations often work to deploy better technical experts or salespeople or accountants instead of seeking ways to increase value delivery to customers and get paid for it. The result is that companies become more efficient in doing things customer do not value and will not pay for.

Some companies have responded by organizing around customer segments. Others have created "matrix" organizations in which employees have both technical and customer responsibilities. Unfortunately, these organizational forms deal with some of the customer facing problems functional organizations create, but they often do so with lower productivity and at very high costs. Bottom Line: No organizational form has yet been identified to create effective customer value creation at low cost.

What does work is creating a culture in which the productive creation and delivery of value to target customers drives the activities of all employees regardless of organizational structure. Key to senior management activity is creating focus across the entire organization:

  • Focus on target customers - All employees readily identify who the target customers are, what their businesses are all about, and what the organization does to create and deliver value to the target customers. In a well focused organization, target customers are real people to employees across the organization.
  • Focus on delivering differentiation - All employees understand how their organization creates value in a way no competitor does. And employees clearly understand their individual role in this differentiation.
  • Focus on the offering - All employees are clear about what the organization does and does not deliver to each target customer segment, and why this offering delivers value to the target customers. Further, all employees see how their individual jobs contribute to creating, delivering, and communicating differentiation.
  • Focus on consistent value delivery - The organization concentrates on delivering the designated differentiation value in every customer interaction. Senior management builds and optimizes organizational assets and capabilities so employees can deliver the designated differentiation value.
  • Focus on profitability - All employees understand the finances of their organization and how their individual jobs contribute to financial success.

Reducing and Eliminating Damaging Price Negotiations

When customers demand lower prices, many companies commit a fatal mistake: they agree to the lower price while holding in place all other terms of sale. In this scenario, the products and services, delivery conditions, delivery location, etc. remain constant while price is lowered.

Why is this a fatal mistake? Because customers quickly learn that they get lower prices without giving up anything - simply by demanding it. Imagine a sales negotiation in which the customer demands a lower price and gets it with no penalties. What customer behavior can be expected in the next sales call? Exactly the same - increasing demands for lower price. The customer has learned that there is no "punishment" associated with lower price demands - but there is a "reward," the lower price.

There is a straight forward technique for dealing with aggressive customer price demands. Instead of negotiating price, sales people should negotiate the offering. In this scenario, sales people negotiate offering elements that reduce value delivery through removing offering elements. This requires management establish two key elements of value based approaches:

  1. Value delivery to customers - The value impact of each offering element must be determined, quantified, and communicated to target customers. When customers ask for a lower price, the sales person can then show the customer what offering element is eliminated from the offering and the economic (value) impact of its removal. The customer is then forced to decide if the loss in economic value is justified by the lower price.
  2. Offering bundles - The exact trade-offs sales people are permitted to offer customers must be defined in advance. Negotiating price often leads to the anarchy of wide spreads in realized price. Negotiating offering elements with no boundaries can lead to a wide spread in what customers buy, and resulting high operations cost. A critical step to negotiating offerings is defining what offering elements sales is permitted to remove when customers insist on lower prices.

Negotiating offerings instead of price teaches customers there is a cost to getting a lower price. Customers learn they must trade-off offering components to get a lower price.

Negotiating offerings instead of price has a further benefit. When price is negotiated customers force their suppliers to deal with the lower price dilemma. Suppliers must deal with the decision to lower price in the face of much uncertainty: how will customers and competitors react to the lower price. When offerings are negotiated, customers must deal with the decision dilemma: can they justify giving up the value contained in the removed offering elements in order to get the lower price. This balances power between the supplier and the customer.

Summary

Price problems are rarely pricing problems! Although many companies face demands for lower price, this does not always mean prices are too high. Demands for lower price may be caused by inadequate competitive differentiation, bad negotiating policy, failure to communicate value, and even by neglecting to ask for higher prices.

Companies who grant price reductions in the face of aggressive customer buying behavior train their customers to seek even more price concessions. To deal with aggressive customer buying behavior, managers must learn to:

  • Clearly target customers where differentiation can be achieved at competitive advantage.
  • Focus the entire organization on the creation and delivery of value to target customers.
  • Negotiate offering elements not price.


George E. Cressman, Jr. is a Senior Pricer and Director at the Strategic Pricing Group where he specializes in the chemicals industry and other business-to-business markets. George has over 28 years of experience in the Chemicals industry, having worked in positions of pricing, marketing and business management, finance, research and manufacturing. He has consulted with clients in Europe, South America and Asia in areas of pricing strategy, marketing strategy, competitive strategy and marketing research. He has held Business, Sales, and Marketing Management positions at DuPont, Monsanto, and Union Carbide. Currently, Mr. Cressman is a Trustee of the Marketing Sciences Institute, a member of the Advisory Board for the Institute for the Study of Business Markets, and a Visiting Scholar at the University of Virginia. George holds an undergraduate degree in chemical engineering, an M.B.A., and his doctoral work is in marketing. George can be reached at 781-466-7726 or via email at gcressman@strategicpricinggroup.com.

The Strategic Pricing Group provides consulting and training services in three areas:

  • Improving marketing processes through developing and implementing value based marketing and pricing strategy.
  • Managing competitive dynamics.
  • Making profitable marketing decisions through understanding and application of relevant costing.

Strategic Pricing Group works with business-to-business firms of all sizes. Their web site is www.strategicpricinggroup.com.

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Copyright 2002 by George E. Cressman. All rights reserved.

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